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Real Exchange Rates: What Money Can Buy

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What is the exchange rate at which a country’s goods are valued against the goods of another country or group of countries?
How do you determine if a currency’s fundamentally undervalued is overvalued? This question is the foundation of international economics, as well many trade disputes.

George Soros was able to answer the question once. In 1992, he had made a successful $1 billion bet against the British Pound. It marked the beginning of an era in large-scale currency speculation. Soros and other speculators who believed the pound was undervalued caused the British currency to crash, forcing the United Kingdom to abruptly exit the European Exchange Rate Mechanism (ERM), which was the precursor of the common European currency, Euro. The United Kingdom never went back to the common currency.

In the years that followed, Soros and other speculators did not repeat the feat. The economists profession does not have a foolproof way to determine when a currency is correctly valued. This is not surprising considering the fact that the exchangerate is a key price in economics. There is however a measure that can provide the answer, and there are plenty of data: the real currency rate (RER).

What do things really cost? Cambio Euro Real

Most people are familiarized with the nominal currency rate. It is the exchange rate of one currency to another. It is often expressed as the national price of the foreign currency. If a U.S. Dollar Holder has to spend $1.36 on one euro, the nominal rate of a euroholder is 0.735 Euros per dollar. However, the nominal exchange rates are only part of the story. If a person or business purchases another currency, they are interested in what it can be purchased with. Which currency is better? Euros or dollars? This is where the RER comes into play. It is used to compare the value of goods from a country with those of other countries, groupings of countries, or the rest the world at the prevailing nominal currency rate.
What is the actual exchange rate?

The real exchange (RER) rate between two currencies is the result of the nominal rate (the cost in dollars of a euro), and the ratio of prices between them. RER = eP*/P is the core equation. Here, e is a nominal dollar/euro exchange rates, P* represents the average price for a product in the euro region, and P* is the average US price.

E is 1.36 in the Big Mac case. If the German price of 2.5 euros is equal to the U.S. $3.40 price, then (1.36)X (2.5/ 3.40) gives you an RER value of 1. However, if the German price is 3 euros, and the U.S price is $3.40 then the RER will be 1.36 X 3.40 or 1.2.

You can calculate the real exchange rate of two countries by looking at a single representative item, such as a Big Mac, a McDonald’s sandwich. If the real exchange rate was 1, the burger would have the same cost in the United States as it would in Germany if it were expressed in a single currency. If the Big Mac costs $1.36 in America and 1 euro (or any other European countries using the euro), this would be true. This world is a one-product market, where the prices are equal to the exchange rates. In this case the purchasing power parity for the dollar and euro is equal and the RER 1.

Let’s say the burger costs 1.2 euros in Germany. It would cost 20 percent more in Germany, which would indicate that the euro has been 20 percent overvalued in comparison to the dollar. The nominal exchange rates will have to adjust if there is an abnormally high real exchange rate (1.2). This is because the same goods can be purchased cheaper in one than the other. It would make economic sense for dollars to be bought and used to purchase Big Macs from the United States at 1 euro each, and then to sell them in Germany for 1.2 Euros. Arbitrage is when arbitrage takes advantage of these price differentials. Arbitrageurs will buy dollars to purchase Big Macs for sale in Germany. As a result, the nominal exchange rate increases and the demand for dollars goes up. Eventually, the price in Germany was the same as the one in the United States. The real world has many costs that prevent direct price comparisons, including transportation, trade barriers and consumer preferences.

However, it is a fundamental idea that RERs can diverge and currencies will be under pressure to change. Overvalued currencies face the pressure to decline and undervalued currencies, to appreciate. Sometimes, it can get complicated if there are factors like government policies that prevent normal equilibration between exchange rates. This is often a concern in trade disputes.
Many products

You could compare purchasing power between countries when they sell more than one item. Economists measure the real currency rate by using a broad range of goods. A basket’s price is expressed as an index number. The consumer price index (which includes both goods and service) is an example of this. The RER can also be used as an index that can easily be benchmarked over any given time period. If an RER Index is 1.2, then the average consumer price of Europe relative to the selected benchmark would be 20 percent higher. Indexes are not used to measure absolute prices, like the Big Mac price, but rather changes in overall prices relative a base year. (Example: If an index is 100 in 2000, and 120 in 2011, then the average prices will be 20% higher than they were in 2000.

RER-indexes can be of great importance between countries. The U.S. massive trade deficit with China has become an important political and economic issue. This is regardless of whether the roots are in a fundamentally wrong-aligned exchange rate.

However, most economists and policymakers are more concerned with the real effective rate (REER), when assessing a currency’s overall alignment. The REER represents the average of bilateral RERs from a country to each of its trading partner, weighted according to the trade shares of each. The REER is an average of the bilateral RERs between a country and each of its trading partners. It can indicate that a country is in “equilibrium” (no overall misalignment), if its currency has been overvalued relative one or more of these trading partners, as long as it has been undervalued relative other currencies.

The REER series of time can provide a rough estimate of when a currency is undervalued and how much. There should not be any changes in currencies that are in equilibrium, just like the absolute or relative RERs. Because consumption patterns change more quickly than those created by statisticians, as can trade policies, tariffs and transportation costs, deviations in REERs are not always indicative of fundamental misalignment.

However, REERs’ volatility has increased despite the fact that transport costs and tariffs declined rapidly over the past century, and national consumption baskets became more uniform. REER fluctuations within the 30 percent range were common in advanced economies a century ago. In the 1980s, swings in the US’s REER were as large as 80 percent. Similar events have occurred in other countries.
Other things to do at work

Not all REER fluctuations should necessarily be taken as a sign of misalignment. There are some large REER adjustments that are very smooth. This indicates that factors other than transportation costs, tastes, tariffs and tariffs may also play a role in the REER for a currency that has not been misaligned.

Technology changes that lead to productivity increases in goods frequently traded between countries, known as tradables are one example of such factors. The REERs would rise in order to maintain equilibrium because productivity increases cause lower production costs. Not all goods in a particular market basket can be traded and are subject to international price competition. Houses and other personal services are not subject to international price competition. Although tradable prices should generally be comparable across countries, there can be significant differences in prices for nontradable items. Economic theory and data support the idea that most of the REER variations between countries can be attributed to fluctuations in nontradable prices.

It is possible for REERs to differ between countries due to persistent changes in terms trade (such as those experienced by oil producers) and differences in fiscal policy, tariffs, or financial development. When estimating the “equilibrium REER”, the IMF and other analysts consider real exchange rate fundamentals. This is the base around which the actual REER should hover, if there are no misalignments.

Because prices can be quite sticky in the short-term and the nominal exchange rate cannot (in countries where the exchange rates are determined by market forces), it can be challenging to estimate equilibrium RERs. Therefore, REERs often show significant short-run volatility in reaction to news and noisy trading. It is not surprising that market participants and policymakers make mistakes sometimes very frequently. It can cause huge realignments, which can have disastrous consequences such as the 1992 ERM Crisis. Although imperfect, REERs have been a sign of large exchange rate undervaluations in the wake of financial crises. This has made it crucial for the IMF to monitor bilateral RERs as well as multilateral REERs.